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Abstract

Corporate governance research has been driven by underlying assumptions and perspectives that are predominantly based on our understanding of US publicly listed companies and US capital market constituents with an emphasis on shareholder value maximization. Yet today, public companies face a changed governance landscape driven by the growth in passive funds, the dominance of the Big Three index funds, and the emergence of activist hedge funds. In addition, increasing investor emphasis on environmental, social, and governance matters has led to a shift away from shareholder primacy. While public companies face an altered governance context, scholars for the most part have not paid attention to the ramifications of these developments on corporate governance and strategic decision-making. We articulate the factors that have emerged and identify opportunities for future research that will lead to greater insight and a more comprehensive understanding of how the changed governance landscape is influencing managerial and board decision-making and firm outcomes.

Keywords

boards corporate governance investors management activist hedge funds

Corporate governance research: assumptions and perspectives

Corporate governance or how publicly listed corporations should be governed is an important topic of both scholarly and practitioner interest. Corporate governance has been defined in various ways from “the system by which companies are directed and controlled” (Cadbury, 1992) to “the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment” (Shleifer and Vishny, 1997: 737). The protection of shareholder rights has been a principal driving force in understanding the evolution of corporate governance. In the United States, the Penn Central bankruptcy of 1970 and the widespread use of bribes to conduct foreign business brought corporate governance to the forefront and resulted in formal guidelines as to the composition of boards and their duties and responsibilities to firms’ shareholders by the American Bar Association in 1976. During the 1980s, hostile takeovers and leveraged buyouts were attributed to a misalignment between managerial incentives and those of the firms’ shareholders (Jensen and Meckling, 1976). During the early 2000s, corporate scandals, including Adelphia and Enron, and WorldCom’s bankruptcy in 2002—the largest in corporate history—significantly undermined investor confidence in the financial markets, resulting in Securities and Exchange Commission (SEC) requirements that CEOs certify their financial statements and the passage of the Sarbanes–Oxley Act in 2002. While in the United Kingdom, a Committee on the Financial Aspects of Corporate Governance chaired by Sir Cadbury issued a report in 1992 that was the first to provide a voluntary code of best governance practices. As its history illustrates, corporate governance is not static, but driven by critical events (e.g. corporate malfeasance, market for corporate control, investor activism) that draw attention to governance issues. Not only is it subject to events arising in the business world, but corporate governance also evolves in response to expectations about corporate behavior which stem from social norms about the firm’s moral, economic, and organizational obligations. These beliefs or views about acceptable and unacceptable corporate behavior influence the guidelines, pronouncements, regulation, and governmental oversight of corporations as well as the professional norms or practices adopted by publicly listed companies.

Scholarly attention has had a significant influence on framing the debate about corporate governance. Jensen and Meckling (1976) defined the concept of agency cost due to the separation of ownership and control. While shareholders are assumed to be wealth maximizers, managers may possess other objectives that have a detrimental effect on shareholder wealth (Fama and Jensen, 1983). Whereas agency theory has been the primary theoretical lens in governance research, scholars in management have recognized that social context and behavioral factors also influence corporate behavior (Westphal and Zajac, 2013). Institutional theory (DiMaggio and Powell, 1983), upper echelons theory (Hambrick and Mason, 1984), behavioral theory of the firm (Cyert and March, 1963), network theory (Moliterno and Mahoney, 2011), and impression management theory (Goffman, 1959) as well as other perspectives have enabled a better understanding of the underlying mechanisms that influence corporate behavior. The utilization of different frameworks and narratives has enabled a broader view of corporate governance and provided novel insights.

Despite the diversity of theoretical frameworks, there are some commonalities in the scholarly work conducted. Most corporate governance research has been conducted on US publicly listed firms, which have several unique characteristics that affect corporate governance. First, as a common law country, the United States gives shareholders strong protection while many countries (e.g. all of continental Europe) operate with a legal tradition of civil law, which gives investors weaker legal rights. Second, the dominance of institutional investor ownership of public companies in the United States is not the norm elsewhere where family ownership (e.g. Latin America), the state (e.g. China), and banks (e.g. Japan, Germany) may have significant ownership. Third, stock exchange listing requirements and governance structure vary by country. Fourth, CEO duality, which comprises 41% of the S&P 500 (Spencer Stuart, 2021), is not practiced or barred (e.g. the United Kingdom) in most of the rest of the world. Finally, executive compensation in US companies is heavily comprised of incentive pay in the form of stock options. Since research has predominantly utilized a US empirical context, our understanding of corporate governance is very US centric.

What has changed? Redefining corporate governance

Shareholder landscape

One of the key factors that has altered the corporate governance context is the substantial rise in passive ownership in the form of index or exchange-traded funds (ETFs), which now comprise 54% of the US equity market (Seyffart, 2021). Index funds hold relatively illiquid and permanent ownership positions (Fichtner et al., 2017) since they track a market index. In particular, the “Big Three” index investors—BlackRock, State Street Global Advisors, and Vanguard—dominate the equity market, holding approximately 25% of voting shares and constituting the largest shareholder in 88% of S&P 500 firms (Bebchuk and Hirst, 2019; Fichtner et al., 2017). Given the magnitude of their equity ownership, the Big Three hold significant shareholder power and have begun to influence governance outcomes. For instance, the Big Three played an instrumental role in the proxy contest of activist hedge fund Engine No. 1’s campaign against ExxonMobil in 2021 for board representation. While Engine No. 1 held only 0.02% of the stock, the support of the three major index investors was essential to their success in gaining three board seats. As Bebchuk and Hirst (2020) note, how the Big Three “monitor, vote in, and engage with portfolio companies has a major impact on the governance and performance of public companies” (pp. 1–2).

In addition to the rise of index funds, activist hedge funds now represent an important constituent in the corporate world (Ahn and Wiersema, 2021). Once focused mostly on US targets, hedge fund activism has become a global phenomenon with consequences for both the control and governance of public companies. Hedge funds are better positioned than other institutional investors to engage in activism as they are subject to less SEC regulations in terms of disclosure and investments and have deployed significant amount of capital demanding a variety of governance- and strategy-related changes, including board representation, CEO dismissal, corporate restructuring, or sale of the target firm (Brav et al., 2015).

The changing shareholder landscape driven by the growth in index funds, the dominance of the Big Three, and the emergence of activist hedge funds have significantly altered shareholder engagement with management and the boards of public firms. Historically, institutional investors could be expected to be highly supportive of management and there was little need for firms to engage with their investors. However, this is no longer the case as activist investors pose a direct threat over the control of the firm and hence have been referred to as the “wolf at the door” (Coffee and Palia, 2016). Given the size of their stakes, activist investors lack control and depend on the support of firm’s other investors to have influence. Thus, management and boards must now be more proactive in their engagement with the firm’s shareholders by communicating with investors beyond the earnings seasons, having regular one-on-one meetings, and improving both the quality and the quantity of disclosures to address investor concerns (Karpf et al., 2020).

In summary, the changes in firm stock ownership due to the growth in index funds, the Big Three, and activist hedge funds have altered the shareholder landscape in significant ways and are likely to have implication for corporate governance.

Shareholder primacy

As noted previously, corporate governance has historically had a strong shareholder primacy perspective. However, growing concerns about the adverse effect that corporations are having on society and on the environment in particular have led to a shift away from shareholder capitalism. Environmental, social, and governance (ESG) issues have consistently been regarded as a risk factor in the past, yet concerns over ESG have surged in recent years within the financial community. The most noticeable change is in the shift in investor interests. In the past, ESG issues were driven mostly by corporate gadflies—a select group of individuals submitting shareholder proposals on a specific environmental or social issue (e.g. air quality of Nike’s factory in Vietnam, Nestle’s use of child labor in the Ivory Coast). Gadflies were “perceived as a mere inconvenience” (Kastiel and Nili, 2021: 572) both for management and the shareholders of the firm. However, the recent surge of investor interest in ESG matters is not driven by corporate gadflies but originates from large institutional investors such as the Big Three or Norway’s Oil Fund. This is a key departure from the past since investors with significant shareholdings now have expectations that firms not only deliver on financial performance but also be held accountable on ESG issues. These investor expectations stem from shifts in social norms about what constitutes acceptable or appropriate corporate behavior. Thus, ESG issues are no longer marginal and have resulted in a shared understanding within the investment community. Investors are engaging with portfolio companies and placing significant emphasis on ESG issues, with considerations such as climate, worker safety, diversity, and inclusion driving investment decisions (Flammer, 2013). Institutional investors, especially the Big Three, support an increasing number of ESG-related shareholder proposals and have voted against the reelection of directors on companies where there is lack of ESG oversight (Araujo and Muzikowski, 2021). In response to the increased scrutiny and expectations of investors, boards are redefining their governance structure and practices with the establishment of ESG committees and a more regular assessment of the company’s progress and public disclosures on ESG efforts.

Moreover, investors’ focus on ESG issues have led to a significant movement centered around redefining the purpose of the public corporation to encompass the interests of all of the firm’s constituents (Fisch and Solomon, 2020). The growing awareness and interest in the environmental and social responsibilities of companies have led to a shift away from shareholder primacy toward more of a stakeholder perspective on corporate governance. In the words of Larry Fink, the CEO of BlackRock in 2019, “To prosper every company must not only deliver financial performance, but also show how it makes a positive contribution to society.” In August 2019, 182 CEOs of major US firms signed a statement issued by the US Business Roundtable to focus corporate governance around a multi-stakeholder perspective and highlighted the importance of corporate purpose. European countries are also pushing for legislative changes to incorporate the interests of stakeholders in corporate purpose. The United Kingdom has been leading this movement through several reforms such as the Companies Act 2006 and the Modern Slavery Act 2015, attempting to enhance companies’ accountability for ESG issues. France also passed legislation in 2019—“Pacte Statute”—to require companies to define their corporate purpose and to incorporate ESG considerations in their bylaws.

To summarize, increasing investor emphasis on ESG issues has had a significant influence on the purpose of the corporation to go beyond a focus on just shareholders and toward a consideration of all stakeholders. ESG has now become an integral part of corporate strategy, and boards and management must incorporate ESG considerations in their decision-making.

Future research agenda

The above highlighted changes to the shareholder landscape and the increasing attention of companies, investors, and governments on environmental and societal concerns have had a significant influence on the governance of publicly traded firms. Yet, unlike research in the field of finance, scholars in management, for the most part, have not kept abreast of many of these developments and instead continue to conduct research based on invalid assumptions about the nature of the firm’s institutional investors, as well as the composition and structure of the board. In addition, our lack of awareness of the constituents in the capital market has resulted in governance research being seriously out of touch with the reality that the boards and management of public corporations face. By not being well informed about the phenomenon you are studying, research on corporate governance fails to be either relevant or insightful.

The changed shareholder landscape and the shift away from shareholder primacy, however, provide an opportunity for new avenues of scholarly inquiry. While corporate governance research in management has principally focused on internal mechanisms of governance (e.g. the board), the shifts in the governance landscape point to the increasing importance of externally based mechanisms (e.g. the investment community) in influencing corporate governance. Below we highlight how this provides scholarly opportunity for governance scholars in management.

Rise of index funds and the big three

The growth in index funds and the emergence of the Big Three have led finance scholars to examine the governance implications of the dominance of passive investors (Appel et al., 2016; Bebchuk and Hirst, 2020). From an agency theory perspective, Bebchuk and Hirst as well as others (e.g. Strampelli, 2018) have made the argument that index funds managers are not likely to be effective external monitors and may “defer excessively to the preferences” of management given their limited investment in monitoring the companies in their portfolios. This is why some have called them “lazy investors” (Economist, 2015). While other scholars argue that their inability to exit their positions may motivate index funds to be more engaged owners (Carleton et al., 1998) and that given their large equity holdings, they may be able to exert influence (Appel et al., 2016). The Big Three state that they are “active” shareholders as exemplified by Vanguard’s statement, “As practically permanent owners of the companies in which our fund invests, we use our voice and our vote to improve governance practices and drive long-term value for investors” (Vanguard.com), while BlackRock states, “We emphasize direct dialogue with companies on governance issues that have a material impact on sustainable long-term financial performance” (BlackRock.com). Yet, their actual voting behavior reflects that they rarely oppose management in shareholder proposals (Fichtner et al., 2017).

Given the significant equity positions now held by index funds, the question arises as to how and in what way they influence corporate governance and strategic decision-making. While finance scholars study the voting and stewardship behavior of index funds, the management literature has not paid much attention to the role of institutional investors on corporate governance and in particular has not acknowledged that it is not just the extent of their shareholdings that matter but also the type of institutional investor. Despite not being able to exit their investment positions, index funds with their significant stakes present a considerable force to reckon with and thus are likely to influence corporate governance. Research is needed to examine not just their voting behavior but also the level and type of engagement that occur between these passive investors and the management and boards of the companies in which they invest. Thus, the rise of index funds provides management scholars with an opportunity to shed light on whether and how these investors are influencing the governance landscape.

Interactions among the firm’s investors and the management and boards of the firms in their portfolios lend itself to an ideal setting to apply theories with social psychology foundations such as impression management or influence tactics (Bolino et al., 2016). Larry Fink, the CEO of BlackRock, utilizes his position as head of the world’s largest institutional investor, to issue an annual letter to CEOs where he communicates, “themes that I believe are vital to driving durable long-term returns and to helping them reach their goals” (BlackRock.com). While scholars have found that executives employ impression management tactics such as ingratiation to change the perception of the firm’s investors (Westphal and Bednar, 2008), there is an absence of research on whether investors also use impression management or influence tactics to change the perceptions and behavior of the firm’s board and management. BlackRock’s attempt to influence firms’ CEOs and how firms respond to these efforts provide a rich research opportunity to examine the result of these engagements. Given the growth and size of index funds and the Big Three as well as the expectation that management and the board must be more proactive in their engagement with the firm’s shareholders, research is needed to provide greater insight as to how these passive institutional investors are influencing corporate governance and strategic decision-making.

Activist hedge funds

The emergence of hedge fund activism in the capital markets has led management and finance scholars to examine how activist hedge funds influence the strategic outcomes of public firms (Brav et al., 2015; Wiersema et al., 2020). Given that the motivation of activist investors is to enhance shareholder value and thus make a gain on their investment, the majority of prior research has been centered on the performance consequences of hedge fund activism.

While scholars have found activist campaigns to have a positive impact on the performance of target firms (Brav et al., 2015; DesJardine and Durand, 2020), our knowledge of how activist hedge funds influence the corporate governance of target firms remains limited. Specifically, strategy scholars have noted that an examination of hedge fund activism from a behavioral perspective is in order (Ahn and Wiersema, 2021; DesJardine and Shi, 2020). An activist campaign does not occur in a vacuum but within a social context involving multiple constituents. Thus, hedge fund activism offers a fruitful setting to apply theories with social psychology foundations as a driver of interactions among various parties involved in the governance of corporations.

The most visible governance change brought on by activist campaigns may be the composition of the board. The most frequent request of activist investors is board representation, which has resulted in 1600 activist appointed directors during the past 8 years (Activist Insight, 2021). Activist directors are predominantly appointed to the board because of a settlement with management and the board rather than through proxy voting by shareholders. These board appointments have resulted in an external monitor of management—the activist investor—becoming an internal monitor of management. Our understanding of whether the appointment of activist directors may influence corporate governance is not well understood. Socio-cognitive theories of group behavior such as homophily theory (Byrne, 1971) and social identity theory (Hogg, 1992) may prove insightful in understanding how board dynamics and decision-making may be influenced by the presence of activist appointed directors. Both social identity theory and homophily theory would suggest that interpersonal attraction among members of a group such as the board leads to group cohesiveness. These theories help to explain why boards lack the independence to be effective monitors of management. Since activist directors represent “unwanted outsiders,” theories of intergroup behavior are likely to be highly relevant to understanding the impact of activist-appointed directors on governance outcomes. Qualitative research is called for to better understand how the appointment of activist directors influences board dynamics and whether they can increase the effectiveness of board oversight and accountability.

Another area that calls for research attention is the engagement between activist hedge funds and other institutional investors. Lacking control, activists need the support of the firm’s other institutional investors to succeed. As a result, activist investors will issue letters addressed to the firm’s management and board but intended for the firm’s investors to draw awareness and scrutiny to the campaign and to convince these constituents that their demands have merit. Similarly, the target firm may also issue letters to communicate their side of the activist campaign. Research examining the use of social influence tactics by the activist and by the target firm may shed light as to whether the firm’s institutional investors will side with management or provide support for the activist’s campaign. Such research would provide greater knowledge on the campaign process and the factors that influence the eventual outcome.

Shareholder primacy

While the premise of a stakeholder orientation is not new (Freeman, 1984), there has been renewed interest on the role of corporate governance on environmental sustainability (see Aguilera et al., 2021, for a review). In particular, scholars have called for the need to refine the theory of “stakeholder governance” (Amis et al., 2020) and to redefine the purpose of the corporation (Mayer, 2021; Mayer and Roche, 2021), recognizing that the current form of corporate governance emphasizing shareholder value maximization is limited in its ability to incorporate the interests of stakeholders (Barney, 2018). This focus on stakeholders has thus refueled the debate on “where does an organization’s responsibility end (McGahan, 2020: 8)” and what form of stakeholder governance is more effective than others (Bridoux and Stoelhorst, 2022).

The core of this debate centers around the way in which stakeholder governance foster creation, appropriation, and distribution of value within the organization (Bacq and Aguilera, 2022; Cabral et al., 2019; Klein et al., 2012). Scholars have argued that “what value to create and for whom, how to appropriate and to distribute among intended stakeholders” (Bacq and Aguilera, 2022: 29) depend on the perspective of different organizational actors on the claim rights of stakeholders (Klein et al., 2019). In other words, creation and appropriation of the firm value are influenced by how CEOs, boards, and shareholders view and interpret the claims of each stakeholder.

To better understand how CEOs, boards, and shareholders perceive the stakeholder claims, organizational theories with cognitive foundations may yield important insights. For instance, extant research on upper echelons theory (Hambrick and Mason, 1984) has provided substantial insights into how individual characteristics and backgrounds of executives influence organizational outcomes (see Neely et al., 2020, for a review). While a few notable studies have yielded important findings on how CEO and board characteristics such as their personal values (Adams et al., 2011) and their political ideology (Gupta et al., 2021) may influence their shareholder orientation and corporate social responsibility (CSR) decisions, research has largely been limited in incorporating executive and board characteristics in developing the theory of stakeholder governance. Integration of upper echelon theory into stakeholder governance research may provide a better understanding of how management and the board perceive stakeholders and ESG issues. For example, are CEOs with higher level of humility more likely to focus on ESG issues and increase corporate social performance? Are board members with experience of ESG activism more inclined to establish board ESG committees and provide oversight on the company’s progress on ESG? An examination of how the personalities or prior experiences of CEOs and board members influence board governance on ESG issues and executive decision-making might lead to interesting findings.

To understand the impact that the focus on ESG issues by the investment community is having on firms’ governance and decision-making, an attention-based view (ABV) may also prove insightful. According to ABV, managers’ attention is selective and is drawn to “dramatic happenings that focus sustained attention” (Nigam and Ocasio, 2010: 823). The increased investor focus on stakeholders and ESG issues in particular represents such events. Large institutional investors are focusing on ESG performance and holding management and the boards of the firms accountable. Despite extensive research on examining the determinants and the consequences of CSR (see Aguinis and Glavas, 2012, for a review), our understanding of how investors’ concerns regarding ESG issues have influenced management and boards remains limited. There is an opportunity for scholars to investigate changes in board or managerial attention toward ESG matters by analyzing the communications of management with investors during their quarterly earnings calls.

In light of the demand for ESG investing, investors are looking for ways to better assess a firm’s overall ESG performance given the limitations of current measures and targets which can be easily green washed. While for investors, there has also been increased scrutiny as to the claims they make for their ESG funds. In the United States, the SEC is considering a proposal to improve disclosures by ESG funds and enhancing its focus on climate-related disclosure in public company filings, while in the United Kingdom, the Green Claims Code provides details as to how businesses should make claims about ESG. Arriving at sustainability metrics to evaluate companies is not a trivial issue. While applying ESG metrics uniformly across firms may be appropriate for measuring corporate governance, it may not be applicable for measuring environmental or social performance since industries vary considerably on these factors. Furthermore, the inconsistency and lack of standards and disclosure of ESG data by companies pose a significant challenge for ESG investors. Measuring a firm’s performance more inclusively provides both a research opportunity and a major challenge to management scholars in that most ESG and CSR metrics are wholly inadequate.

Research focused on environmental sustainability is not only growing in the field of management but also in accounting and finance (see Gillan et al., 2021, for a review). For instance, scholars have explored the role of institutional investors on firms’ CSR performance (Chen et al., 2020; Dyck et al., 2019) and whether their sustainable practices affect firm performance and value attributes (Bolton and Kacperczyk, 2021; Ferrell et al., 2016). Specifically, the research on sustainable finance has examined shareholders’ growing preference toward sustainable investments such as corporate green bonds (Flammer, 2021), green municipal securities (Larcker and Watts, 2020), or socially responsible investment (SRI) funds (Riedl and Smeets, 2017). By becoming familiar with the scholarly work done in finance and accounting, management scholars can gain further insight into the role of investors on influencing expectations and the adoption of ESG practices by boards and management.

Finally, while the United States is the predominant focus of corporate governance research, different regions and countries possess a multitude of unique contexts that offer tremendous opportunities for future research on corporate governance. The study of Yan et al. (2019) examining SRI funds across 19 countries shows how country-level institutional factors such as unions, political parties, and religion may affect the founding of SRI funds. Contextual differences such as the European Union’s lead on adopting policies that are intended to reduce pressures on the environment also provide opportunities to examine how companies and boards are adapting to imposed regulation. Asia’s cultural contexts such as power distance orientation may breed indigenous leadership characteristics (Koo and Park, 2018), which may also alter ESG decisions by management and affect organizational and strategic outcomes. Recognizing that certain governance forms may be more adapt in dealing with distinct social issues (Luo and Kaul, 2019), distinct governance structures such as business groups in Asia or family businesses in Europe may contribute to variance in the role of stakeholder governance on organizations.

Conclusion

As stated in the Cadbury (1992) Report, “corporate governance is changing, and is expected to change in the future” (p. 1). In this essay, we highlight key changes in the corporate governance context over the past two decades and provide scholars a roadmap for future research. The newly transformed shareholder landscape and the shift toward a stakeholder perspective from shareholder primacy present unique contexts for scholars to capture today’s dynamic aspects of governance in their studies. We encourage governance researchers to look beyond the traditional agency-theoretic assumptions and adopt a multitude of theoretical lenses highlighted in our paper to enrich our understanding of governance mechanisms at work among organizational actors, environmental context, and firm decision-making.

Footnotes

Funding

The author(s) received no financial support for the research, authorship, and/or publication of this article.

ORCID iD

Margarethe Wiersema

Author biographies

Margarethe Wiersema holds the Dean’s Professorship in Strategic Management at the Merage School of Business at the University of California, Irvine. She has an MBA and PhD from the University of Michigan. She is internationally recognized as one of the leading experts on corporate strategy and corporate governance with more than 60 publications and over 13,000 citations. Her research has appeared in the New York Times, The Financial Times, The Economist, Fortune, Business Week, and the Washington Post. She serves on the board of the International Corporate Governance Society and on the senior advisory board of the Global Strategy Journal. She is a Strategic Management Society Fellow and served as Dean of the Fellows of the Strategic Management Society (2009–2021), Associate Editor of Strategic Management Journal (2009–2018), Associate Editor of Academy of Management Perspectives (2019–2021), Associate Editor of Academy of Management Review (2011–2012), and on the Board of Directors of the Strategic Management Society (2006–2010). Address: Paul Merage School of Business, University of California, Irvine, Irvine, CA 92697, USA. [ email: mfwierse@uci.edu]

Haeyoung Koo is an Assistant Professor in the Department of Management at City University of Hong Kong. Her research explores the intersection of corporate governance and strategy, focusing on the behavioral aspects of firms’ decision-making processes and their strategic implications. Prior to joining the doctoral program, she worked as an investment banker at Goldman Sachs and Morgan Stanley in New York, advising clients on various strategic alternatives, including mergers and acquisitions, capital raising, and activist defense. She received her PhD in Management from the University of California Irvine; MBA from University of Pennsylvania, Wharton School; and BA from Brown University. Address: City University of Hong Kong, Kowloon, Hong Kong. [ email: haeyokoo@cityu.edu.hk]

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Corporate governance in today’s world: Looking back and an agenda for the future

Abstract

Keywords

Corporate governance research: assumptions and perspectives

What has changed? Redefining corporate governance

Shareholder landscape

Shareholder primacy

Future research agenda

Rise of index funds and the big three

Activist hedge funds

Shareholder primacy

Conclusion

Footnotes

Funding

ORCID iD

Author biographies

References